Waiting For The Stock Market Bubble To Burst?

Wall Street is doing backflips—overjoyed—as the markets surge. Stories and reports flood the landscape with projections of sustained growth in the markets.

In other words, the stories produce unfettered exuberance, spurred on by higher prices and optimism born more from wishful thinking than reality. The fact is, as you watch your account balances grow, you will use each high as your new bar for success.

There are several key issues to consider during this time of a raging bull market.

Well, it’s time for a reality check: History has shown us time and time again that this will end, markets will correct to fair value, and speculators will get crushed.

The discussion is not about market timing! Beware that the “pundits,” “experts,” and newsletter writers who have sold their clients on their “ability” to know when to pull out are playing a game of Russian Roulette with five chambers filled with bullets. You might get lucky and pull the trigger on the empty chamber, but the odds are not in your favor that your luck will hold out very long.

There are several key issues to consider during this time of a raging bull market:

It’s time not timing. The amount of time your money is invested is more related to success than you might think. Unless you are a die-hard believer in winning the lottery (and you have some secret knowledge to bring in favorable results), you want to gauge your exposure to the stock market based on when you need to access these funds and how much risk you’re willing and able to take on. The longer time you have, the likelihood of growth becomes higher. In other words, if you have a short time until you need to utilize the investment, you are taking on a greater risk of failure.

Diversification. Sure, being well and properly diversified in your portfolio sounds boring. It’s way more interesting to buy the hot stock or the hot sector with the goal of reaping excitingly high returns. However, if you ascribe to the old saying that “Man Plans and God Laughs” you might find yourself on the wrong end of excitement. Spreading your investments among many varying asset classes is more conservative and the smarter path to take if you want your investments to grow over time. Yes, the expected returns might assuredly be less than the returns delivered by the hot stock or sector, but consider how you would feel if you saw your nest egg evaporate on a wish and a prayer. Think twice before putting all your eggs in one basket.

Understand risk. Human behavior plays a huge role in investment success, and success in general. Humans tend to feel comfortable when they feel part of something, rather than being the lone wolf standing away from the crowd. It’s that group behavior that feeds into the frenzy of “before it’s too late” syndrome. The bottom line is that there are safe investments and risky investments. One is not better than another, but you should focus on how much you hold in each, which is dependent on two factors: your time horizon and your ability to put your head on the pillow at night.

Interest rates can’t produce the results you want. If you are waiting for interest rates to beat inflation (long term), you likely have a super long wait. Interest rates produce a return less than inflation, especially if you’re invested in short term bonds. So, is the answer to have a safe interest rate investment to buy long-term bonds? That would be an emphatic NO! Long-term bonds are extremely volatile. Locking in a bond for twenty or thirty years means that you are guaranteed that rate over that time period, regardless of where interest rates move (up or down). If interest rates fall, your bonds will most likely be called and you’ll have a lower rate bonds to choose from with the proceeds of the called bond. If rates increase (with inflation), then the value of your bond decreases and the rate you’re getting is lower than market. It’s a lose-lose scenario.

How do these issues tie into the idea of the stock market bubble bursting? I’m glad you asked.

The more you understand the markets, investments, risk and return and your own beliefs and behavior, the better equipped you are to make sound decisions. If you are invested properly for your time horizon and ability to withstand market volatility, you’ll get through the next correction without losing sleep or making bad decisions; such as selling when markets are low because of fear. This is where understanding that the crowd mentality, all the terrible news stories of doom and gloom, will prompt you to make a potential terrible decision.

If you are a DIYer, consider getting a second opinion from a fee-only advisor who will consult with you and not try to sell you anything.

If you are working with a broker who earns their living from buying and selling, that second opinion is a great idea too.

Corrections are normal, just as bull markets, flat markets, recessions. If you are following the herd in making your financial decisions, consider the cost of making mistakes and work towards a measured and well-conceived plan that will help you avoid disasters—and more importantly, put you on a path towards financial success.

Multi-Factor or Not Multi-Factor? That Is the Question

Let’s pretend you are a US investor that wants to deploy some of your money overseas. You think international developed market stocks are attractive relative to US stocks, and you also think the US dollar will decline over the period you intend to hold your investment. Your investment decision is logical to you. But you have choices: You could a) simply invest in a traditional index like the MSCI EAFE, b) invest in a fund that systematically emphasizes a single factor (like a value fund) that only buys specific stocks related to that factor, or c) invest in a developed fund that blends several factors together, like the JPMorgan Diversified Return International Equity ETF (JPIN). What is the best choice?

Investing in a traditional international market capitalization index like the MSCI EAFE is not a bad choice. It has delivered nice returns for a US investor, especially uncorrelated outperformance in the 1970s and 1980s, and helped to diversify a US-only portfolio.

Your second choice is to invest in one particular factor because it makes sense to you. Sticking with the example of a value strategy, you might believe a fund or index that chooses the cheapest or most attractively valued stocks based on metrics like Price to Earnings (PE) is best.

You could go find a discretionary portfolio manager who only buys stocks he deems to be cheap. Typically the concept of “cheap” is based on some absolute metric that the manager has in mind, such as never buying a stock with a PE greater than 15. If there are not enough stocks that are attractive, he will hold his money in cash until he finds the prudent bargains he seeks. This prudence also obviously risks possible underperformance from being absent from the market.

The alternative is to buy a value index or fund that systematically only buys the cheapest stocks in a particular investment universe. So if there are 1000 investable stocks available, the index ONLY buys the cheapest decile of 100 stocks and is always fully invested in the 100 securities that are relatively cheapest. This is an investment approach that a discretionary manger may disdain. The discretionary value manager may look at those same 100 stocks and think they are pricey. But nevertheless, academic research has shown that always being fully invested in the relatively cheapest percentiles of stocks in the US has produced superior returns over many decades.

Such a portfolio is called a “factor” portfolio. Why the name? In the early 1960s, academics introduced the concept of beta and demonstrated that individual US stocks had sensitivities to, and were driven by, movements in the broad market. In the early 1990s, academic research began to show that other “factors” such as value and size also drove US stock returns. Since then, several factors have been identified as driving individual stock outperformance: value, size, volatility, momentum and quality. Stocks that are cheaper, smaller, less volatile, have more positive annual returns and higher profitability have historically outperformed their peers. It turns out these factors also work internationally.

Of all the factors, value is the factor that has been the best known the longest (even before it was academically identified as a “factor”), thanks to the books of Warren Buffet’s teacher Ben Graham. And if you look abroad at an array of developed global markets and create a value index and compare it to its simple market capitalization weighted brother, the historic outperformance of value has been stunning. Until recently.

While there was some variability by country, on average from the mid-1970s up until 2005 a value factor portfolio in a developed market outperformed its market cap weighted index by about 2% a year. That’s a lot. By contrast, since 2005, the average developed country value portfolio has underperformed a market cap indexes by about -40 basis points. Which is the danger of investing in one factor. It may not always work at every point in time.

So if investing in one factor like value runs the risk of underperforming, how about a multi-factor international developed equity portfolio?

Below is a breakdown of individual factor portfolios’ performance in international developed equity markets since 2005, an equal weighted factor portfolio as well the performance of the MSCI EAFE as our performance reference. Note that, for the last 13 years, value has been the poorest factor by far, while the others have handily beaten the EAFE. An equal weighted portfolio of all 5 factors, while not as optimal as some of the individual factor results, beats the EAFE by 1.6% and has an information ratio, or risk adjusted returns that are superior by 37%. The equal weighted factor portfolio also has the advantage of not having to predict which factor will work when, so even when a factor like value does not beat the market, the other factors can pick up the slack.

SOURCE: MSCI, Data as of January 31, 2018. Past performance is no guarantee of future results. Shown for illustrative purposes only.

The equal weighted factor portfolio has one other advantage over the market cap weighted alternative. Note in the chart below how well the portfolio outperformed in the 2008 crisis, so it tends to do relatively well in highly volatile sell offs.

SOURCE: MSCI, Data as of January 31, 2018. Past performance is no guarantee of future results. Shown for illustrative purposes only.

While it’s not inconceivable that one or two of these factors could erode, or underperform for a stretch, the fact that you have exposure to multiple factors in a portfolio that seems to do especially well in crises suggest the multi-factor blended portfolio remains the most attractive way to invest in developed markets.

So, when asked the question: Multi-factor or not multi-factor? The data speaks for itself.

DEFINITIONS: Price to earnings (P/E) ratio: The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.

DISCLOSURES: MSCI EAFE Investable Market Index (IMI): The MSCI EAFE Investable Market Index (IMI), is an equity index which captures large, mid and small cap representation across Developed Markets countries* around the world, excluding the US and Canada. The index is based on the MSCI Global Investable Market Indexes (GIMI) Methodology—a comprehensive and consistent approach to index construction that allows for meaningful global views and cross regional comparisons across all market capitalization size, sector and style segments and combinations. This methodology aims to provide exhaustive coverage of the relevant investment opportunity set with a strong emphasis on index liquidity, investability and replicability. The index is reviewed quarterly—in February, May, August and November—with the objective of reflecting change in the underlying equity markets in a timely manner, while limiting undue index turnover. During the May and November semi-annual index reviews, the index is rebalanced and the large, mid and small capitalization cutoff points are recalculated.

Investors should carefully consider the investment objectives and risks as well as charges and expenses of the ETF before investing. The summary and full prospectuses contain this and other information about the ETF. Read the prospectus carefully before investing. Call 1-844-4JPM-ETF or visit ww.jpmorganetfs.com to obtain a prospectus.